Wednesday, August 12, 2009

Economic Forecasts for 2010.

It is a difficult time for economic forecasting. At the start of 2008, many economists were predicting only a mild slowdown. The scale of the recession took many by surprise. It seemed that whenever the worst was over, more unexpected bad news came along.

Given the parlous state of the economy at the end of 2008, expectations were pretty low for 2009. Given the dismal expectations at the start of the year, things have not turned out quite as bad as the worst forecasts. This does not mean the economy is doing well. It just means, that it could have been a lot worse. (for example, markets were recently cheered by the fact US unemployment only rose 0.5m last month - they expected a lot worse)

Forecasting for 2010 is difficult given the mixed signals still coming from economy. Despite the recent positive news, it seems the Bank of England is still fearing deflation and a Japanese style double dip recession. Their recent message pulled no punches saying this is one of the worst recessions ever. Mervyn King said:

“We’ve been through an extraordinary financial crisis... One doesn’t need to ask questions about 'the worst since when’ since it may be hard to find any period in which it was actually worse.” (link)

On the back of news that GDP is likely to fall by a record 5.5% this year, it is understandable why the Bank of England has extended the policy of quantitative easing.

Why Fears of Japanese style prolonged slump.

Manufacturing output has tentatively picked up. However, this is to be expected after inventories slumped during the worst of recession. It remains to be seen whether this improvement in manufacturing output is sustained or just a reaction to low inventories. The fall in GDP of 5.5% in 2009 is the steepest in the post war period and there is a large amount of spare capacity - indicated by rising unemployment.

The Economy is being propped up by unprecedented government and monetary policy intervention.

Large Budget Deficit (e.g. Tax cuts which are due to expire)

Zero interest rates

Quantitative easing

Bailout of banks

Weak Pound

However, in 2010, there is little, if any, room for fiscal expansion. In fact the government may face the tricky task of reducing borrowing during a fragile recovery. Also, 2010 will see the expiration of 15% VAT and other tax breaks. It remains to be seen whether consumer spending will hold up after these sweeteners are removed.

Many fear, if interest rates are increased too quickly, the economy could be plunged back into recession. Arguably, this is what occurred in 1937 and in Japan in their 'lost decade'

Some of the 'positive signs' are also potentially misleading. The recent bounce in equity markets may help confidence but, it's hardly an economic fundamental.

One promising sign is that house prices appear to be stabilising - admittedly on extremely thin levels of mortgage approvals. But, stability in house prices will be important for the British consumer nervous about spending. But, the stability in prices could still prove to be short lived.

The prospects for 2010 therefore depend on the attitude of Central Banks and governments. It appears the Bank of England is more concerned with deflation than inflation and they have stated they will do everything to avoid a prolonged depression. This indicates interest rates could remain low for a protracted period. (I wonder whether the prudent ECB will have sufficient flexibility to put aside their long standing anti-inflation concern and keep rates low.)

My personal feeling is cautiously optimistic. I think things will get better. But, that doesn't mean we will see a return to a period of rapidly rising living standards. As the Bank of England point out, the next few years will see a period of economic austerity as bank lending and consumer spending remain subdued. Also, tax rises and spending cuts are quite likely in next few years.

Forecasts For Interest Rates

The Bank of England suggest interest rates could stay at 0% for the first half of 2010.

Forecasts for Inflation

The Bank of England suggests inflation could go below its target of CPI 1-3%. There is no sign yet of inflationary pressure from quantitative easing or a weak pound

Forecasts for Growth

Growth will be positive in 2010, but still below the trend rate

Forecasts for Unemployment

Unemployment may peak below 3 million. But, although unemployment increased slower than forecast, it may take a lot longer to decrease. Also, many workers are facing prospect of having to take on part time work.